The article below is Aon’s quarterly market review and outlook with perspectives on market activity and current investment trends:
What is happening in markets and what special considerations are there for rebalancing now?
What does the current interest rate environment mean for DB plans and how liability-driven investment strategies and implemented?
What are Opportunity Allocations and how can they be used to help investors be nimble when trying to access investment opportunities?
Continue reading to learn more about market trends in the first quarter of 2020.
While we had a negative view of risk assets prior to this quarter, nobody could have predicted the COVID-19 pandemic and the ensuing halt of the global economy. Lockdowns continue in the United States, Europe, and other parts of the world and they are expected to stay in place for the foreseeable future. New York remains the epicenter of the outbreak in the United States, although there are signs that social distancing measures are starting to slow the tide of patients requiring hospitalization.
U.S. GDP growth remained stable at an annualized 2.1% in Q4, the same as it was in the third quarter of 2019. Continued gains in consumer spending as well as a shrinking trade deficit helped growth during the fourth quarter. Unfortunately, it is now almost certain that global GDP will fall into negative territory during the first and second quarter of 2020 and consensus is that it will fall below levels not seen since the Global Financial Crisis in 2008/9. The manufacturing sector in most developed countries started the year off strong as many countries ended February with a manufacturing Purchasing Managers’ Index (PMIs) over 50 (levels which are consistent with growth in activity). However, most developed countries, including the United States and United Kingdom, ended the quarter with PMIs well under 50 due to a sharp decline in new orders, production, and price levels. The Consumer Confidence Index fell to 120 in March, the lowest it’s been in 32 months, and will most likely fall even further as the latest survey date was only as of March 19th. We expect more dismal economic numbers ahead as a result of government enforced lock downs of economies around the world.
In response to the growing realization of the economic impact of the virus, fiscal and monetary policy (discussed below) responses gathered momentum towards end of the quarter. While not globally coordinated, the size of the fiscal stimulus has been large. The UK response was early and impressive in terms of loan guarantees and income subsidies to employees and self-employed, which will allow companies to retain staff despite decreases in revenue, whilst other countries followed with similar plans shortly after. These are packages not seen outside of wartime for most nations. The US Congress passed Phase III of their COVID economic stimulus, The CARES act, which will amount to approximately 10% of GDP or over $2 trillion. The package includes direct payments to residents, extended unemployment benefits, aid to specific industries, and financing for companies to keep workers employed. The hope is that the new stimulus will help curb the increase in unemployment, which was shockingly high in the last two weeks of March and insulate some of the economy from this enormous shock. Initial jobless claims for the week ending March 28th were 6.6 million, doubling the number from the week before. The previous record for claims filed in one week was 695k in 1982. The St. Louis Federal Reserve predicted the unemployment rate will increase to over 30% in the coming months.
In other developments, Brexit negotiations stalled during the quarter as the United Kingdom and the European Union clashed on “level playing field” requirements. U.K. Prime Minster Boris Johnson declared that Britain would be prepared to leave the E.U. on World Trade Organization rules if progress is not made by June 2020. Subsequent negotiations have been delayed as European countries have focused on the global pandemic.
The economic and financial market uncertainty will make the upcoming US Presidential election even more interesting. After lagging in early contests, Democratic nominee candidate Joe Biden enjoyed a strong comeback on Super Tuesday and is now seen as the heavy favorite to win the Democratic nomination. The early frontrunner, Bernie Sanders, performed poorly and has seen his chances for nomination dwindle. Sanders is a self-described democratic socialist while Biden has built his campaign on being the stability and “decency candidate”. President Trump will continue to focus on the early health of the economy and mitigating the impact of the COVID-19 pandemic. His chance of re-election will be tied to voter perception of how he handles this crisis. A re-election for Trump would likely be the most market supportive, whilst a victory for Biden may bring some equity market headwind but not as significant as the scenario of a Bernie Sanders victory.
In response to the growing pandemic, major central banks have done everything in their power to provide stable and low-cost funding for surging government borrowing needs and keeping the financial system awash with liquidity to ensure orderly markets. Many global central banks cut rates during the quarter, with the two notable exceptions being the Bank of Japan and the European Central Bank whose policy rates were already negative. The Federal Reserve made two emergency inter-meeting rate cuts during March. The first cut was 0.50% which was followed shortly by a second cut of 1.00% leaving the target range for the federal funds rate at 0 to 0.25%. These were the two largest individual rate cuts in over a decade and the first intermeeting moves since the financial crisis in 2008. The Fed Funds rate cut, desire for dollar-based assets, and flight to government backed treasuries drove the 10-year treasury yield below 1.00% for the first time in history. Following the Fed’s move, the Bank of England cut interest rates to a record-low of 0.1%.
The Federal reserve also introduced several programs to stabilize the economy and ensure credit continues to flow. The Fed restarted their quantitative easing program and announced they will purchase treasury and mortgagedbacked securities “in the amounts needed” to support smooth market functions. In an unprecedented move the Fed also announced they will be buying corporate investment-grade bonds in the secondary market through a new special purpose vehicle. Quantitative easing was also ramped up in other economies outside of the US, notably in the Euro Area.
Global equities fell sharply during the first quarter as the coronavirus outbreak turned into a global pandemic. Major equity indices fell more than 20% below the mid- February peaks in the fastest bear market on record ending the 11-year bull market, the longest on record. For the quarter the Dow Jones US Total Stock Market Index returned -21.0% while the returns for the MSCI All Country World Index were slightly lower at -21.4%. Growth continued to outperform value over the quarter with the MSCI All Country World Growth Index and the MSCI All Country World Value Index returning -15.7% and -27.1% respectively (all returns in net terms). Returns were on pace to be much worse before stock markets rallied to end the quarter. Large fiscal stimulus packages were credited as the major reason for improving risk sentiment. The unfortunate likelihood is that new market lows and more volatility are probably still ahead.
It is our view that equity market valuations have become a little more attractive and may warrant an increase in allocations for those willing to ride out near-term volatility., We cannot say that valuations are in outright “cheap” territory quite yet, especially relative to previous bear market troughs. Earnings growth estimates have started to be adjusted downwards but remain far too optimistic for the next 12 months – estimates vary on 12 month earnings forecasts but a figure of -30% is not impossible. On the other hand, there is one way in which equity markets can be considered cheap and that is relative to bonds. The Equity Risk Premium for the US market is back to highs last seen in 2013, which is obviously due to very sharp falls in bond yields. We suggest that portfolios begin to reduce underweights to risk assets and begin the journey towards, but not all the way to, a neutral allocation to equities using a phased approach.
Market volatility was excessive during the quarter. The CBOE Volatility Index (VIX), Wall Street’s “fear gauge”, set a new record peak of 82.7 in mid-March before ending the quarter slightly lower at 53.5 after having averaged 19.0 over the previous 12 months. We expect volatility to continue in the near-team. When uncertainty subsides, opportunities will emerge driven by dislocation caused in the financial markets.
The rapid reassessment of the economic outlook took a dramatic toll on credit assets during the quarter. Credit spreads widened materially. Credit spreads widened across the curve over the quarter with investment-grade yields increasing 204 basis points and high yield spreads increasing 517 basis points. The pandemic has created the conditions for a drastic rise in default and downgrade risks. Ratings agencies such as Standard and Poor’s and Moody’s have already begun to downgrade companies and Moody’s recently projected that the default rate could approach 10% for high-yield corporate bonds. A segment of the market that was very hard hit was residential and commercial mortgage backed securities as the economic downturn reduced the probability of rent payments being made in a timely manner. This, coupled with highly levered positions, caused several funds in this area to liquidate many assets, adding to stress.
On top of the reassessment of credit risks, credit markets faced acute stress in facilitating transactions. The market’s flight to cash drove up bid-ask spreads, making it very difficult to sell and buy fixed income assets, even investment grade. After the Fed’s intervention in investment grade markets some normality is beginning to appear with companies beginning to issue bonds again, but the costs to transact continue to be elevated. In subinvestment grade markets, normality is also beginning to return too, but unlike the investment grade market the Federal Reserve is not buying these bonds.
Much like equities we believe that there is better value now in credit markets, but they could get cheaper when the true damage to the economy is revealed and we get more clarity on the path of the recovery. We believe that investment grade markets should be favored over riskier parts the credit markets, and that an active approach should be taken when deploying capital in these markets. Further, we believe that selective opportunities driven by market dislocations will begin to appear as the dust settles.
Government Bonds and Yields
The combination of economic damage caused by the Pandemic, and the response of easing monetary policy caused yields to fall across the curve. The rate cuts, along with decreases in global output, caused 10-year US treasury yields to decrease by over 120 basis points to 0.68%, the first time in history it fell below 1.0%, and it remained there at the end of the quarter. Looking to the long-end of the curve, we also saw unprecedented moves. The 30-year yield began the quarter at 2.39% and ended the quarter at 1.27%, a decline of 1.12%. The 30-year yield briefly closed below 1% on March 9,2020, a sign of how stressed the outlook had become. The steep decline in yields led to very strong performance for longduration U.S. Treasury bonds with the Bloomberg Barclays U.S. Aggregate Treasury Over 20-Year Index returning 21.5% for the quarter. U.S Treasury bonds returned 8.2% in the quarter, measured by the Bloomberg Barclays U.S. Aggregate Treasury Index.
With central banks cutting rates and ramping up their QE programs, it is tough to envision rates rising from their depressed levels anytime soon, despite a large amount of issuance to come from government fiscal assistance for their economies. This implies that returns are likely to be low for government bonds, unless we see another large move down in government bond yields – something that looks relatively unlikely at the moment. We recommend that portfolios use gains from government bond portfolios to fund asset purchases in other markets or as a source of liquidity versus other asset prices that have become depressed.
Commodity prices tumbled during the quarter with the S&P GSCI index falling 42.3%, the largest one-month decline in the index’s almost 30-year history. The oil sector was hit the hardest with Brent crude returning -61.7% and WTI returning -67.1% during the quarter. Oil faced a simultaneous negative demand and supply shock. The pandemic caused demand for oil to decrease as the virus (and associated social distancing) decreased car usage and airline flights became almost non- existent. At the same time, Russia and Saudi Arabia were unable to come to an agreement on continued production cuts.
In response, Saudi Arabia ramped up production and offered significant discounts to consumers in direct competition with Russian suppliers. This price war brought prices down well below shale oil’s breakeven level of $49p/bl, essentially pricing US shale producers out of the market. Agricultural commodities were hurt by both price depreciation and negative roll return, leading to a return of -9.4% for the quarter. Gold was the only major commodity sector to produce a positive return during the quarter, although performance was not as strong as some expected. Despite being seen as a safe-haven asset, Gold lost 0.1% in March.
Quarterly Total Return for Q1 2020 by Currency
Asset Class Return Matrix
Market data sourced from Factset. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.
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